Over the past 2 months, Arthrocare and its management have acted like nothing is wrong with their company and all criticisms have been nothing more than noise from short sellers. If you read the stories quoting Arthrocare officials, you get the impression of a company just minding its own business, conscientiously selling its surgical devices to willing surgeons like a hot dog vendor at the ballpark.

CEO Baker has gone as far to say only a few days ago that he spends his day fighting web stories about soured relationships with insurance companies and business practices. Mr. Baker continued, calling Citrons criticisms as “are “the most salacious kind of garbage you can possibly find.”

Meanwhile, Citron maintains that Arthrocare’s financial results are dependent on an upcoding scheme for insurance claims. The various aspects of this willful and systematic business model have been all documented indisputably in the company’s actual sales literature, as published on Citron.

Trouble at Arthrocare

Enter Gerda Silien. Mrs. Silien, an employee of The Marriot was hit in a minor car accident. The case seems to be a routine auto accident / minor injury case, defended by an insurance company…. the kind insurance companies routinely settle. So why is this one being intensely litigated?

State Farm, one of the largest payers of these claims, is using this lawsuit to expose the chain of relationships to stop a pattern of very high settlements brought about by aggressive surgical interventions – all with the same procedure coordinated by Discocare/Arthrocare. It is important to note that these subpoenas are not normal course of business legal work, rather they set the stage to challenge the legality and sustainability of the “Discocare model” which Arthrocare plans to implement throughout their company.

Discocare Subpoenaed

On October 16, 2007 Discocare was served with a subpoena from State Farm Insurance. Ironically, it is the same State Farm Attorney that took the deposition earlier in the year of Dr. Jeffrey Kugler. This subpoena was not just an “ordinary course of business” document as they did not ask for just the medical records of the plaintiff. Rather, it goes out of its way to question the business model of Discocare.

“Any and all certifications from Arthrocare for Arthrowand Procedures, Arthrocare Training Manuals, or Arthrowand Seminars from Arthrocare on Arthorwand and or Percantaneous Disc Procedures.”

“Any And All Literature or billing guidelines which would support Discocare being allowed to bill the patient separately”

And our favorite is the last line which states:

“All records requested should be all inclusive and should in no way be limited to one incident”

The $100 million Cover-Up

The Discocare subpoenas were served on them a full two months before their eventual acquisition by Arthrocare. Not only did management fail to disclose a possible investigation into the business, but they went out of their way to cover it up. First, when allegations of possible misdoings by the spine unit were suggested, Arthrocare responded by buying back $75 million worth of stock without ever addressing the real issues. Not more than 2 weeks later, the company spent another $25 million on the acquisition of Discocare without ever mentioning a current legal attack on their business model. Considering the company only had $50 million in cash at the end of last quarter, they spent DOUBLE their cash attempting cover up their illegal business practices.

All along, CEO Baker and crew were telling Wall Street that any questions about their business models were just rumors made up by shortsellers. Mr. Baker had numerous opportunities in the past two months to inform investors of this issue but instead he denied any investigation, leaving unacknowledged the existence of any pointed legal interrogatories from any insurance company.

Arthrocare Subpoena…Hold on to your hats

Citron hates to editorialize that which needs no explanation. The following subpoena is dated January 23, 2008. Everything you are about to read is the inquiry of State Farm Insurance Company. This is not an “ordinary course of business” inquiry, or just a random subpoena that goes to the legal department. This subpoena is not only directed to the company but also subpoenas for deposition CEO Michael Baker and David Applegate, Vice President of the Arthrocare’s spine unit.

Astute readers will note that previous Citron reports have published a trail through much of this documentation already, showing the investment community proof of suggestive and coached coding at the heart of the squirrelly “Discocare Model”. And for any of you who want to see what a normal course of business subpoena looks like, this is the one for Marriot in the same Gerda Silien case.

Conclusion

Investors should note that the problems at Arthrocare are more than skin deep. It is the opinion of Citron that Arthrocare was planning to apply the so-called “Discocare model” to shore up margins in its stagnant sports medicine business.

Most of all, what can you do when you can no longer trust management? Arthrocare’s potential future liabilities should be of huge concern. Management chose not to disclose any of this, while concurrently squandering their corporate funds on a strategy of denial. This is an obvious invitation to a securities class action lawsuit. It appears indisputable that Arthrocare faces legal battles ahead with the insurance companies and possibly state regulatory or criminal courts. And just when you think those legal battles are over, they may have to face all of the nameless Gerda Siliens of the world, who were pawns in the game of medical care intended to exploit cracks in the health care reimbursement system, and treated according to the priorities of a strategy designed for inflated corporate financial gain.